Ashlea Ebeling, Forbes Staff
I write about how to build, manage and enjoy your family's wealth.
Next year all taxpayers will be allowed to convert their traditional individual retirement accounts into Roth IRAs, just as those earning less than $100,000 have been permitted to do since 1998. This opens up conversions to 13 million households holding $1.4 trillion in traditional IRAs. Not surprisingly, financial advisors and firms are scrambling to market conversions to this affluent crowd.
It won’t be an easy sell. Conversions are complicated and make sense only for certain taxpayers. Even those who might reap big benefits from converting have to overcome a natural aversion to paying taxes sooner than needed. “It’s one of those things that will be oversold and underutilized at the same time,” observes Jeffrey Baskies, an estate lawyer in Boca Raton, Fla.
A traditional IRAs is usually funded with earned income that hasn’t yet been taxed. Investments grow tax deferred, and withdrawals are taxed at ordinary income rates. The top federal rate is 35%, destined (under present law) to go to 39.6% in 2011 and fairly likely to wind up still higher than that. A Roth is funded only with aftertax dollars, but any withdrawals made after five years and past age 591/2 are tax free.
In a conversion you withdraw funds from a traditional IRAs, pay the ordinary taxes due on any pretax contributions and tax-deferred investment growth, and then move the cash into a Roth, where future growth is tax free. (The money doesn’t have to go far. You can keep it in the same mutual fund.) In effect, you’re hedging against higher future tax rates by paying taxes now. You’re also betting Congress won’t double-cross you. While it’s unlikely Roths will be taxed directly, Congress could find ways to tax them through the back door–for example, by counting Roth withdrawals to make more of your Social Security taxable or to levy higher, income-based Medicare premiums on you. “It’s a legitimate concern,” concedes Robert Keebler, a Wisconsin CPA and conversion advocate.
So if you’re already making annual contributions to a Roth 401(k) or Roth IRAs, that may be enough of a bet–and simpler to boot. But not everyone is eligible to make contributions (see “First, Contribute”), and a conversion can move more cash into a Roth quickly.
If you’re about to retire and will need to draw from your IRAs for your own living expenses soon, you’re usually not a good conversion candidate.
On the other hand, if you’re retired and so well fixed you would like to leave your IRAs to your children or grandchildren, you are a prime candidate. That’s because of another advantage to Roth IRAs: While you must begin withdrawing funds from a traditional IRAs the year after you turn 70 1/2, you and your spouse can leave a Roth untouched and growing for your entire lives. Your heirs must take minimum annual distributions but can stretch these over their own projected life spans, giving them decades of additional tax-free income and growth. A Roth can also reduce state and federal estate taxes, since you’ve sliced the nominal size of your estate by prepaying income taxes for your heirs.
Whatever your age, if you won’t need the money in your pretax IRAs for a decade or more, you might be a good candidate–if your tax rate will be the same or higher in retirement. Don’t rush to convert just because taxes for the affluent are likely going up. It’s your own combined federal and state income tax rate that matters, and that could go down if you’re moving from California or New York to Nevada or Florida. Leave your money in a traditional IRAs, make the move and then–if conversions are still allowed–reassess.
Finally, if you have made nondeductible (meaning, aftertax) contributions to a traditional IRAs or 401(k), you may be a good candidate, since the taxable income you have to recognize will be reduced by those contributions. The rules say the amount you convert must be drawn proportionately from your pretax and aftertax IRAs, so your savings depend on the mix of accounts you have. Craig Brimhall, vice president of retirement wealth strategies for Ameriprise, planned ahead; during 2006, 2007 and 2008 he made $15,000 in nondeductible contributions to a traditional IRAs for his wife, Melanie. It’s now worth $14,700. Since she doesn’t have any pretax IRAs, she can convert the account to a Roth tax free.
Whether a conversion is worthwhile depends in large part on how much tax you have to pay up front and where you get the money to pay that tax. It’s best to pay the tax on the converted IRAs from other piggy banks, not from the IRAs itself. If you are younger than 59 1/2, the dollars you withdraw from an IRAs to pay tax will usually get hit with a 10% early withdrawal penalty, as well as with ordinary tax. (The amount converted to a Roth is subject to ordinary tax but no penalty.)
Yet another weird trap for high-income folks: Taxpayers who convert in 2010 can either recognize the resulting income in 2010 or split it between 2011 and 2012. You have to elect to recognize it in 2010, and the natural inclination might be to use the 2011-12 option. But top tax rates are likely to rise in 2011 as the Bush tax cuts expire, making delay potentially costly for those with incomes above $250,000. (Remember, that’s $250,000 including the amount you’re converting.) Fortunately, you have until you file your 2010 return–Apr. 15, 2011 or Oct. 15, 2011 with extensions–to decide on when to recognize conversion income.
One way to limit the current tax pain is to convert only the amount that would push you into the next marginal tax bracket. (You don’t have to convert a whole account.) Tax brackets are fairly wide. In 2010 a married couple gets the 15% rate on taxable income up to $68,000 while the next higher 25% rate goes up to $137,300. For singles the 15% rate ends at $34,000 and the 25% rate at $82,400. So a Roth conversion can make sense for someone who has just lost a spouse–a widow(er) gets the benefit of the couple’s tax brackets in the year a spouse died.
A corollary of this is to convert in a year when you have some other extraordinary (usually unfortunate) event–say, big medical expenses or a casualty loss that pushes down your taxable income. Here’s an extreme example: Daniel Nye, a Medfield, Mass. estate lawyer, had an elderly client in ill health who spent $250,000 for medical expenses for his late wife over 2007 and 2008. The man didn’t have much income to deduct those expenses against–he was depleting his assets to pay her bills. So to sop up those deductions, Nye had him convert a $400,000 IRAs into a Roth. He died this year, leaving a tax-free inheritance to his sons.
On a happier note, you can also use big charitable gifts to offset the extra conversion income. Consider donating appreciated stock–it can offset only 30% of your adjusted gross income, but you’ll have a big agi when you convert.
What if your IRAs assets drop in value after you pay the tax? The government gives you until Oct. 15 of the year after you convert to undo the conversion and get a refund of the tax. (It’s called a recharacterization.) You can then try the conversion again after 30 days. With this generous do-over rule in mind, open up a separate Roth each time you do a conversion. Some planners even set up a series of Roths with different asset classes in each. That way, you can undo only the losers.
Another clever move involves money in a traditional IRAs that has been rolled over from a 401(k). Some high earners have made aftertax contributions to those 401(k)s. So Mitchell Drossman, head of national wealth strategies for U.S. Trust, suggests clients who are still working do an “upstream conversion”–they roll pretax 401(k) contributions that were rolled into an IRAs back into their current employer’s 401(k), leaving them an IRAs made up of only aftertax dollars and earnings attributable to them. They can then convert those dollars into a Roth, paying tax on only the earnings. Note that while the law allows this, your current employer might not.